When you save or invest money, two of the most important factors are risk and return.
The risk attached to an investment is a way of describing how likely it is to lose money. For example, a bank deposit account is a safe investment and is therefore very low risk. You could only lose money if the bank became insolvent and the government guarantee of savings up to £75,000 per person through the financial services compensation scheme was not honoured.
Buying shares in a new technology company, on the other hand, may be considered very high risk: there is a possibility that the firm’s products or services may not succeed, which could lead to losses for shareholders.
On a bank deposit account, returns – in the form of the annual interest rate – are relatively low, especially in the UK at the moment given the low bank of England base rate.
With the new technology company example, on the other hand, whilst the value of the investment will go up and down, returns could be much higher over the longer term if the firm is a success or if it is bought by a larger rival.
For most individuals, buying shares in one or two companies may be an excessively risky approach to investing.
There are, however, thousands of investment funds which hold a wide range of assets, such as shares, bonds and property on behalf of thousands of private and institutional investors. These funds use the investing principle of diversification to reduce their risk: there is a lower probability of all the assets in a fund falling in value at the same time, so there is less chance of investors losing their money.
Over the longer-term – usually five years or more – investment funds can often be expected to provide higher returns than cash savings accounts, which is particularly important given the effect that inflation can have on cash holdings. This is why they are more often used for long-term savings such as pensions.
However, with most types of investments, such as those in company shares, there is no guarantee that your money is safe.
When you are making investment decisions, you need to establish your attitude to risk.
For example, consider how long you will be able to leave your money invested, and whether you can afford to suffer any losses, even if they are temporary. If you might need the cash in a few months’ time to pay for a holiday or a new car, say, a savings account is likely to be a safer, more sensible option.
But if you are planning to save for many years, for example to help you pay for retirement or to put your children through university, taking on more risk in the hope of generating greater returns over the longer-term may be more appropriate.
If you only put money into cash savings accounts, your future returns may be limited in line with interest rates. Only by taking on more risk can you give your money the opportunity to grow over the long term.
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